Financial Rule-Makers Must Learn to Use Their Calculators

Jan. 28 (Bloomberg) -- Believe it or not, U.S. financial
regulators don’t have to calculate the economic impact of the
rules they write. It’s an omission they should correct before it
becomes a serious obstacle to fixing the financial system.

The term “cost-benefit analysis” is gaining prominence as
the battle over the 2010 Dodd-Frank financial-reform act moves
into the courts. Lawyers working for corporate lobbies have
challenged several rules on the grounds that the authors failed
to fulfill adequately a legal requirement: Regulators must
evaluate or consider -- not necessarily quantify -- the costs
and benefits of new rules.

Courts have already struck down two Dodd-Frank rules, one
designed to curb speculation in derivatives markets and another
aimed at giving shareholders more say in the selection of
corporate directors. The next targets could be higher-profile
items, including the forthcoming Volcker rule, which seeks to
prohibit short-term speculative trading at federally insured
banks.

It’s easy to portray the legal challenges as typical
financial-industry tactics. Problem is, they’re effective
because they have a valid argument. Regulators’ cost-benefit
assessments have largely failed to meet the low standards set by
the law. And even if they succeeded, they would still fall short
of what common sense demands.

Crucial Element

Consider the level of analysis that has so far accompanied
a crucial element of financial reform: New capital requirements
that would make banks more resilient in times of crisis. In the
proposed rule issued by the Federal Reserve and other agencies,
the cost estimate amounts to a calculation of how many hours
bank employees will spend on compliance paperwork. No effort is
made to quantify the benefits. As a result, opponents of higher
capital requirements have been able to dominate the conversation
with specious warnings that the new rules will harm economic
growth.

Financial regulators protest that forecasting the effect of
an untested new rule can be difficult, particularly when one
must weigh relatively certain costs against hard-to-quantify
reductions in the likelihood of crises. Somehow, though, other
agencies manage to do it. When, for example, the National
Highway Traffic Safety Administration issued new emissions and
fuel-efficiency standards last year, it included more than 50
pages with tables quantifying everything from the added cost to
manufacture specific automobile brands to the benefit of reduced
highway fatalities due to lighter cars.

Agencies that specialize in finance should be able to do at
least as good a job as those that deal with health and safety.
In a recent paper, two University of Chicago professors --
economist Glen Weyl and legal scholar Eric Posner -- suggest a
place to start: Develop a standard statistical cost of a
financial crisis, much like the statistical value of a human
life that agencies such as the NHTSA use to estimate the
benefits of safety rules. Such a measure would allow regulators,
with an educated guess at how much a new rule would reduce the
probability of a crisis, to produce a ballpark benefit estimate
that could be weighed against a rule’s costs.

In a 2011 analysis of bank capital levels, economists at
the Bank of England and the Bank for International Settlements
showed how the calculation can be done. Looking back at nearly
200 years of data, they estimated how much each added
percentage-point increase in capital ratios would lower the
likelihood of systemic crises. They also assessed the effect of
increased capital on banks’ funding costs, interest rates and
economic growth. Using the Bank of England’s own estimate of the
cost of a crisis -- 10 percent of economic output, with a
quarter of the effect being permanent -- they concluded that the
optimal ratio of capital to risk-weighted assets would be about
20 percent, or more than double the level required by the latest
iteration of international banking rules.

Ballpark Guess

To be sure, regulators won’t always have enough data to
produce an empirical estimate of how much a given rule will
reduce the odds of a crisis. That said, even a ballpark guess
has value. It puts a limit on what regulators can claim and
makes them think harder about how different rules might overlap
and interact. If, for example, estimates of how much all the
rules in Dodd-Frank would lower the probability of a crisis add
up to more than 100 percent, that would be a clear signal to go
back to the drawing board.

In short, regulators can let cost-benefit analysis stymie
their efforts to build a better financial system, or they can
use it to their advantage. Need we recommend which course of
action to take?